With Boris Johnson as the UK’s new PM—and given his enthusiasm for Brexit and threat to leave the EU by October 31 even with a “hard” Brexit—it might make sense for companies to revisit the observations of SEC officials regarding the critical need for thoughtful and specific disclosures about Brexit. Note that the designated new head of the EU commission has said that “another extension [beyond the deadline of October 31] could be granted ‘if good reasons are provided’—such as holding a general election or second referendum.” Reports from yesterday, however, indicated that Johnson’s election “has been greeted in Brussels with a rejection of the incoming British prime minister’s Brexit demands and an ominous warning by the newly appointed European commission president about the ‘challenging times ahead.’” To be sure, in terms of potential disruption, some practitioners have likened the havoc that Brexit could create to the chaos anticipated from the Y2K bug! But even if that analogy turns out to be a bit too apocalyptic, there’s no question that Brexit, especially a hard Brexit, could have a significant impact on many companies—and not just those based in the UK and EU. With that in mind, companies may want to reexamine and update their disclosures about the potential impact of Brexit on their businesses.
The SEC and its staff have been quite vocal on the need to disclose the material risks and anticipated effects of Brexit. In a 2018 speech to the FEI Current Financial Reporting Issues Conference in New York, SEC Chair Jay Clayton advised the audience that the SEC was “sharpening its focus on corporate disclosures about the risks associated with the U.K.’s exit from the European Union….‘My personal view is that the potential impact of Brexit has been understated….I would expect companies to be looking at this closely and sharing their views with the investment community.’” And, as reported by the WSJ, Corp Fin Chief Accountant Kyle Moffat has previously cautioned that the “‘staff will be thinking and looking hard at tailored disclosure describing not only those risks associated with Brexit but also the potential impact on the business. It needs to be clear. It needs to be concise. And if there’s going to be an impact, then it definitely should be discussed and it should be discussed in detail.’”
In terms of possible effects, many companies may decide that they need to move headquarters, factories or other facilities or stock up on materials and components. For some companies, one of the most significant issues will be whether they will need to relocate to EU-based banks financial arrangements, such as syndicated loans, swaps and other derivatives, that are currently located at banks in London. That could be a costly, time-consuming and paper-intensive process. As reported in this WSJ article, “regulations that currently cover the City of London, the heart of the U.K.’s and Europe’s financial industry, may stop applying” when Brexit takes effect, which “could make it necessary to relocate thousands of financial products used by corporates to an EU-based financial entity.” Determining if relocation is necessary will likely depend on the results of the final Brexit negotiations—whether the UK and EU were able to agree to a free trade deal that includes financial services and allows the UK to function much like it has with its current “passport”; whether the UK is instead granted equivalence status by the EU, which “allows non-EU financial firms to offer a limited range of mostly wholesale services—such as securities trading and clearing—to European customers provided their home country’s financial regulations are broadly similar to the EU’s”; or, the result that the market appears today to be pricing as increasingly likely, whether the UK “becomes a so-called third country after a hard Brexit” with no agreements in place; or whether some other permutation emerges. Apparently, financial contracts with an aggregate value of approximately $2.7 trillion could be affected. In light of the current uncertainty, companies have also been considering if they need to “repaper” their financial contracts (or will be able to make any needed changes only in future agreements) and the potential impact on hedge accounting. (See this PubCo post.)
In a speech in December 2018, Clayton advised that he had “directed the staff to focus on the disclosures companies make about Brexit and the functioning of our market utilities and other infrastructure.” (Emphasis added.) To that end, Clayton enumerates specifically his key concerns, which although admittedly personal, are also “reflective of the SEC’s approach to Brexit”:
- “The potential adverse effects of Brexit are not well understood and, in the areas where they are understood, are underestimated.
- The actual effects of Brexit will depend on many factors, some of which may prove to be beyond the control of the U.K. and E.U. authorities.
- Our markets, at many levels—from multinational companies, to market infrastructure, to investment products and services—are international, and the effects of Brexit will be international, including on U.S. markets and our Main Street investors.
- The actual effects of Brexit are likely to manifest themselves in advance of implementation dates and, based on corporate disclosures, some of those effects are upon us.
- The actual effects of Brexit will depend in large part on the ability of U.K., E.U. and E.U. member state officials to provide a path forward that allows for adjustment without undue uncertainty, disruption or cost. That is a tall order that I believe requires: (a) a broad understanding of market interdependencies—knowledge that goes well beyond the labor and financial markets; (b) foresight—people and firms will act in their own interests and the interests of their shareholders; and (c) flexibility—miscalculations are inevitable and will need to be addressed promptly. More generally, limiting the adverse effects of Brexit requires a willingness of governmental authorities to look beyond potential immediate, local economic and other opportunities provided by a blunt transition and pursue a course that focuses on broad, long-term economic performance and stability. While many involved in the Brexit process agree with this perspective, and some important steps have been taken, I do not yet see wide acceptance of this principle.”
In remarks in March at the 18th Annual Institute on Securities Regulation in Europe, Corp Fin Director William Hinman discussed the application of a “Principles-Based Approach to Disclosing Complex, Uncertain and Evolving Risks,” specifically addressing Brexit (among other topics). With regard to Brexit disclosure, Hinman offers a very useful cheat sheet of good questions to consider in crafting appropriately tailored disclosure.
To Hinman, the issue of Brexit is especially fraught with uncertainty, and businesses have had to prepare for different possible outcomes and make decisions to mitigate associated risk, which will certainly vary from company to company and industry to industry. With regard to risk-related disclosure, for example, MD&A should allow investors “to understand how management is positioning the company in the face of uncertainties.” Similarly, risk factors should provide investors with material “decision-useful” information that is company-specific by explaining how each risk affects the company, without “bury[ing] the reader in generic boilerplate or laundry lists of risks that might apply to any company.”
In light of the uncertainty associated with Brexit, Hinman observed that “investors are better served by understanding the lens through which each company’s management looks at its exposure. How does management assess and analyze Brexit-related risks and the potential impacts on the company and its operations? What is management doing to mitigate and manage these risks? What is the nature of the board’s role in overseeing the management of these risks?” While recognizing the need for confidentiality of some information, Hinman suggested that the disclosure be evaluated by comparing it to management’s disclosure to the board: are there “material gaps between how the board is briefed and how shareholders are informed. For those of you involved in crafting disclosure documents, you can ask yourself a straightforward question: would these disclosures satisfy the curiosity of a thoughtful, deliberative board member considering the potential impact of Brexit on the company’s business, operations and strategic plans?” To the extent material, Hinman advised, “Brexit disclosure should provide tailored insight into how management views the risks posed to the business and operations and what actions they are taking to address these risks.”
Hinman then offered a number of disclosure topics for companies to consider in the context of Brexit, reproduced in full below. (Hint: Corp Fin may well be asking these same questions in reviewing company disclosures on the issue.)
- “Is the business exposed to new regulatory risk given the uncertainty of which set of laws and regulations will apply and whether transition agreements will be in place? We have seen useful, tailored disclosure by some financial institutions that addresses the regulatory risks associated with the potential loss of passporting arrangements that currently permit U.K. entities to provide services to businesses and customers throughout the EU. Similarly, some firms have provided disclosure explaining specific efforts undertaken to re-locate their U.K. operations, or to merge with or acquire EU subsidiaries, to mitigate the regulatory risks of Brexit. Banking and financial services are obviously not the only industries subject to regulatory risk in light of Brexit. Biopharmaceutical companies with substantial U.K. operations face risks concerning how their products and clinical trials will be regulated. Airlines face risks that potential restrictions on flying rights or changes in administration of antitrust laws may negatively impact their joint ventures. For companies in these industries and others affected by regulatory risk, we would expect tailored disclosure explaining these risks where appropriate.
- “Are there significant supply chain risks due to the potential disruption to the U.K.’s access to free trade agreements with other nations and any resulting changes in tariffs on exports and imports? Will potential changes to customs administrations and delays materially impact a company’s business, particularly if the business relies on just-in-time supply chains? We believe that companies are actively considering the potential impact of these matters on their business, and we look forward to seeing disclosures that provide insight as to how management is assessing and mitigating these risks.
- “Does the company face a material risk of losing customers, a decrease in sales or revenues or an increase in costs due to tariffs or other factors? Is demand for the company’s products especially sensitive to exchange rates or changes in tariffs? Discussion and analysis of these types of questions regarding known trends, demands, commitments, events and uncertainties are critical for investors to understand the extent to which a company’s reported financial information is indicative of future results. To the extent management sees the potential impact of Brexit in terms of anticipated costs, reductions in forecasted sales or changes in working capital, it may be appropriate in some cases to include estimates or ranges of quantitative changes, as well as qualitative disclosures.
- “Does the company have exposure to currency devaluation, foreign currency exchange rate risk or other market risk? Given the potential for heightened foreign exchange volatility, we are aware of reports that companies are increasing their hedging activities. We will look at quantitative and qualitative disclosures about market risk to better understand each company’s approach to market risk management in this area.
- “What is the company’s exposure to contractual risk in the face of Brexit? Has the company undertaken a review of its existing contracts with counterparties in the U.K. or the EU to determine whether renegotiation or termination is necessary in light of contractual obligations? To the extent these discussions involve material contracts, we would expect disclosure to reflect these discussions.
- “Do Brexit-related issues affect financial statement recognition, measurement or disclosure items, such as inventory write-downs, long-lived asset impairments, collectability of receivables, assumptions underlying fair value measurements, foreign currency matters, hedge accounting or income taxes? We expect that boards and audit committees are considering these reporting implications and that these considerations will be discussed in company disclosures, as appropriate.”